Stocktake: US stocks may not be as expensive as they seem

Excluding the late 1990s technology bubble, this is the most expensive US stock market in history. Or is it?

The S&P 500 trades on a cyclically adjusted price-earnings (Cape) ratio of 38 – twice its historical average and near 1999’s record reading of 44. However, valuations aren’t as grave as they seem, says Nucleus Wealth’s Damien Klassen.

In a recent note, Klassen said Donald Trump "broke" the Cape when he slashed corporate tax rates in 2017 from 35 to 21 per cent. Separate research shows tax rates were even higher in the past, topping 50 per cent in the 1960s.

Consequently, investors are (rightly) willing to pay more for a dollar of earnings today relative to past decades.

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Similarly, the Cape should be adjusted for the explosion in corporate buybacks. Accounting for tax and buybacks indicates an adjusted Cape ratio of 29.2 – still high, although well behind today’s headline number.

In a follow-up note, Klassen made further adjustments relating to changed accounting standards and lower trading fees and spreads, among other factors. This made no difference to his original calculations, but adjustments to old Cape readings suggest valuations have often been around today’s levels in the past.

Indeed, while an unadjusted Cape suggests stocks have been overvalued for almost all of the last 20 years, Klassen’s revised metric suggests the last two decades have actually been a “typical investment period with some low valuations, some high”.

Bears might retort that stocks look expensive on multiple metrics, not just the Cape. True – but maybe they’re not as expensive as some Cape crusaders claim.